What causes oil prices to fluctuate?

Oil is a commodity, and as such, it tends to see larger fluctuations in price than more stable investments such as stocks and bonds. There are several influences on oil prices, a few of which we will outline below.

OPEC's Influence on Oil Prices

OPEC, or the Organization of Petroleum Exporting Countries, is the main influencer of fluctuations in oil prices. OPEC is a consortium made up of 14 countries: Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. OPEC controls 40% of the world's supply of oil. The consortium sets production levels to meet global demand and can influence the price of oil and gas by increasing or decreasing production.

OPEC vowed to keep the price of oil above $100 a barrel for the foreseeable future, but in mid-2014, the price of oil began to tumble. It fell from a peak of above $100 a barrel to below $50 a barrel. OPEC was the major cause of cheap oil, as it refused to cut oil production, leading to the tumble in prices.

Supply and Demand, Futures Contract Impacts on Oil Prices

As with any commodity, stock or bond, the laws of supply and demand cause oil prices to change. When supply exceeds demand, prices fall and the inverse is also true when demand outpaces supply. The 2014 fall in oil prices can be attributed a lower demand for oil in Europe and China, coupled with a steady supply of oil from OPEC. The excess supply of oil caused oil prices to fall sharply. Oil prices have fluctuated since that time, valued at approximately $67 per barrel as of April 2018.

While supply and demand affect oil prices, it is actually oil futures that set the price of oil. A futures contract for oil is a binding agreement that gives a buyer the right to buy a barrel of oil at a set price in the future. As spelled out in the contract, the buyer and seller of the oil are required to complete the transaction on the specific date.

Impact of Natural Disasters and Politics on Oil Prices

Natural disasters are another factor that can cause oil prices to fluctuate. For example, when Hurricane Katrina struck the southern U.S. in 2005, affecting 19% of the U.S. oil supply, it caused the price per barrel of oil to rise by $3. In May 2011, the flooding of the Mississippi River also led to oil price fluctuation.

From a global perspective, political instability in the Middle East causes oil prices to fluctuate, as the region accounts for the lion’s share of the worldwide oil supply. For example, in July 2008 the price for a barrel of oil reached $136 due to the unrest and consumers' fears about the wars in both Afghanistan and Iraq.

Production Costs, Storage Impact on Oil Prices

Production costs can cause oil prices to rise or fall as well. While oil in the Middle East is relatively cheap to extract, oil in Canada in Alberta’s oil sands is more costly. Once the supply of cheap oil is exhausted, the price could conceivably rise if the only remaining oil is in the tar sands.

U.S. production also directly affects the price of oil. With so much oversupply in the industry, a decline in production decreases overall supply and increases prices. The U.S. has an average daily production level of 9 million barrels of oil, and that average production, while volatile, has been trending downward. Consistent weekly drops put upward pressure on oil prices as a result.

There are also ongoing concerns that oil storage is running low, which impacts the level of investments moving into the oil industry. Oil diverted into storage has grown exponentially, and key hubs have seen their storage tanks filling up rather quickly. More than 77% of storage capacity is being used in Cushing, Okla., one of these hubs. However, slowing production and pipeline network improvements will reduce the chance that oil storage will reach its limits, which helps investors shed their fears of too much supply and a rise in oil prices.

Interest Rate Impact on Oil Prices

While views are mixed, the reality is that oil prices and interest rates have some correlation between their movements, but are not correlated exclusively. In truth, many factors affect the direction of both interest rates and oil prices. Sometimes those factors are related, sometimes they affect each other, and sometimes there's no rhyme or reason to what happens.

One of the basic theories stipulates that increasing interest rates raise consumers' and manufacturers' costs, which reduces the amount of time and money people spend driving. Fewer people on the road translates to less demand for oil, which can cause oil prices to drop. In this instance, we'd call this an inverse correlation.

By this same theory, when interest rates drop, consumers and companies are able to borrow and spend money more freely, which drives up demand for oil. The greater the usage of oil, which has OPEC-imposed limits on production amounts, the more consumers bid up the price.

Another economic theory proposes that rising or high interest rates help strengthen the dollar against other countries' currencies. When the dollar is strong, American oil companies can buy more oil with every U.S. dollar spent, ultimately passing the savings on to consumers. Likewise, when the value of the dollar is low against foreign currencies, the relative strength of U.S. dollars means buying less oil than before. This, of course, can contribute to oil becoming costlier to the U.S., which consumes almost 25% of the world's oil.

The Bottom Line

There are several factors, both economic and political, that can cause fluctuations in oil prices. OPEC is widely seen as the most influential player in oil price fluctuations, but basic supply and demand factors, production costs, political turmoil and even interest rates can play a significant role in the price of oil.

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